by George Daleiden

“Trading” in the world of commodity futures means entering the market (called taking a position ) and later exiting (called closing the position ).

Taking and Closing Out Positions

In order to trade commodity futures, one opens and funds a futures trading account with a reputable Futures Commission Merchant (FCM), a process similar to setting up a stock brokerage account. Then the typical novice trader enters the market and takes a position: buys (goes long ) or sells (goes short ) a commodity. When traders who speculate go long, they presume the price will rise in an electronic trading exchange, or in the pit on the floor of an open outcry auction market, where the deals are made. The intention of a speculator who is long is to buy low, sell high, and make a profit. Speculators who go short expect the opposite: sell high, buy low, and also make a profit. Hedgers trade largely to lock in prices of commodities in which they have a physical interest, not to profit from price action and volatility

How Can One Sell Before Buying? He or She Doesn’t Even Own It!

It’s done all the time. A hog farmer sells his herd on the futures exchange long before they’re fat and ready for market. A gold mining operation sells when the metal is still in the ground, and a farmer sells his crop before it’s even planted. The historical reason why these markets exist is to facilitate the sale in the future of something that doesn’t yet exist, but is expected to.

The motives of hedgers and speculators are different, but the market makes no distinction between them. The market can’t tell (nor does it care) whether a trader is in the futures market to lock in a price (hedger) or just to make money (speculator).

I’m a Speculator. Walk Me Through Some Trades.

OK. Corn is trading, at 10 AM, for $3.00 per bushel on the Chicago Board of Trade, where the buy-sell action takes place for many commodity grains. The speculator thinks corn’s price is headed higher. He buys—goes long—one contract, 5000 bushels, by executing an order with a broker on the phone or online. His buy order is sent to and filled by a shouting, waving individual in the trading arena (whose language of hand gestures and open outcries are well understood by the other traders in the pit). At that moment the speculator is obligated to take delivery of about 280,000 lbs. of shelled corn—six truckloads—at a cost of $15,000 ($3.00 x 5000), in the future month the contract specifies. He pledged only $1080 of his own money to take his $15,000 position in the market, because he bought on margin, a type of performance guarantee established by the exchange.

Near day’s end, the futures market price of corn has risen to $3.05 per bushel. His contract is now worth $15,250 ($3.05 x 5000). He closes his position by executing an offsetting “sell” order at $3.05, which is quickly executed. He’s now out of the market and rid of further obligation, and has made $250 profit (less brokerage commissions) on a pledge of $1080. He has bought low, sold high, and won. If the market had drifted lower, to $2.95, and he had become nervous and closed his position by selling out, he’d have lost $250, having bought low, sold lower, and lost. For every penny the corn futures market moves, up or down, one gains or loses $50, depending upon one’s position, long or short.

What if a trader believes the market price will, in fact, go down, not up? Then, he would go short, and sell a contract first. If the market declined from $3.00 per bushel to $2.95, he’d profit $250 when he closed out his position by executing an offsetting “buy” order, and exit the market. Then, he has sold high, bought low, and profited the difference. If the price action goes against one’s short position—if it rises—one stands a loss, having bought high and sold higher.

There are many variations of the basic buy-sell and sell-buy strategies, many of them complex and sophisticated. But in the final analysis, success usually hinges on the ability to correctly predict how quickly when and where prices are headed.